Employee versus independent contractor: What’s the difference?
An employee is a permanent member of your team, while an independent contractor is a separate business that provides a service.
The Supreme Court and the U.S. Department of Labor say there is no single rule or test for determining whether an individual is an independent contractor or an employee for purposes of the Fair Labor Standards Act (FLSA). They even have seven factors for determining worker status.
The IRS defines an independent contractor by how they’re employed. Their general rule is that “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.”
Every state has its own set of tests to determine if you’re an employee or a contractor. And once your status is determined, state law may require an employer to provide things like workers’ compensation insurance, fair labor practices, unemployment insurance and more.
Significant legal penalties exist for misclassifying workers to avoid paying for full-time employee benefits.
Talk to your attorney or tax advisor to make sure you understand the laws and rules in your area.
Pros and cons of independent contractor versus employee
| Independent Contractor | Employee |
| Pros | Cons | Pros | Cons |
| Availability | Hired according to contract guidelines and scope of work | May not be available when you need them | Always available during work hours | Many states hire employees at will — meaning you or they could end employment anytime |
| Cost | Contractor pays for insurance, equipment and taxes themselves | May charge higher hourly rates | Lower cost in exchange for lower risk, job security and employer-paid benefits | Employer pays taxes, insurance and salary — even when business is down |
| Liability | Contractor is liable for accidents or mistakes | Hiring entity lacks the reach to prevent problems | Employer can work to help prevent problems | Employer is liable for accidents or mistakes |
| Work environment | Work gets done | No control over how the work is done | Control over how, when and where the work gets done | Responsible for training, supervising and providing resources to complete work |
Contracts for independent contractors versus employees
A contract can help classify employment status, but know this: The default in every state is for a worker to have employee status. Business owners have the burden to prove that a hired worker is an independent contractor.
An employment contract could include employment benefits such as sick days and vacation policies. Independent contractors tend to have contracts without benefits, and they tend to spell out a specific project and its completion goals.
Insurance and liability for an employee or independent contractor
An independent contractor is the owner of their own business, no matter the size. If they cause injury or property damage while on the job, they are responsible, just as you would be responsible if you had caused it.
Contractors often need their own small business insurance to help cover mistakes and accidents. Even if you, the business owner, are insured, providers will not cover losses caused by your contractor because they are separate business owners. This is why some companies require contractors to have insurance before hiring them.
Conversely, an employee’s work or damage they might cause can be insured under your general liability insurance coverage.
If you hire employees for your small business, you will need to pay into unemployment insurance and provide additional types of insurance, including health insurance (if you have more than 50 employees) and workers’ comp.
Employee versus independent contractor compensation
Employers are generally required to cover Social Security payments for employees, but not for independent contractors.
But — a skilled contractor will often expect more per hour than an employee with the same qualifications to make up for the lack of benefits and shared tax burden.
Tax liability for an independent contractor versus employee
There are a number of taxes you’ll have to pay if you hire employees as opposed to independent contractors.
Employees have many more tax responsibilities. Business owners will be responsible for complying with payroll tax requirements. This includes income tax withholding and paying half of the FICA taxes (Social Security and Medicare taxes). You’re also on the hook for unemployment taxes.
Independent contractors pay for these things themselves. They must pay their own income tax and self-employment tax (like Social Security and Medicare). As the business owner who hired the contractor, you need to report the amount you paid them on a 1099-MISC tax form, but you don’t need to withhold or pay FICA taxes for these payments.
The misclassification of independent contractors can bring stiff penalties from labor agencies and the IRS, including:
- $50 for each W-2 that the employer failed to file.
- Penalties totaling 1.5% of the wages for the failure to withhold income taxes, plus 40% of the FICA taxes that were not withheld and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
- A “failure to pay taxes” penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.
And this is if the misclassification was unintentional. If found intentional or fraudulent, the penalties are higher. Aside from fines, an employer could be forced to pay unpaid overtime, fines for break violations, any back taxes and benefits.
Employee and independent contractor labor laws
Employees are covered by numerous federal and state employment and labor laws. These laws offer protections and guidance for topics such as worker safety and health, minimum wage, workers’ compensation insurance, hours worked, employee benefit security and more.
Independent contractors are not covered by federal labor or employment laws. Their rights are largely governed by a state’s contract law and any other provisions states may have regarding their employment status.
